Inflation targeting effectiveness in Ghana's monetary policy

Ghana

Many of the most renowned economists throughout the world believe that inflation targeting is a monetary tool that should be implemented. The management of inflation is essential to ensuring that the economy will be profitable and sustainable over time. Economies that cannot stabilize inflation rates will have difficulty growing and flourishing over the long run and the quality of life for citizens will suffer. The country of Ghana, located in West Africa, has undergone many changes over the past few decades as a result of gaining its independence. With this new found independence came the need to embrace an effectual monetary policy so that the economy can flourish. Monetary Management by the Central Bank as a major arm of economic policy management in Ghana has by law and practice often focused on price stability. Yet over the years in Ghana, monetary policies implemented by the central bank has had a history of strong inflationary pressures from a triple digit in the early seventies and eighties to double digits in the nineties and is currently battling to attain single digit. The study proposes to reveal the effectiveness of Inflation Targeting as a policy tool in managing inflation by the Central Bank. The study will also explain why in the face of falling interest rates the Ghanaian Central Bank still achieves its desired objectives of lower rate of inflation. The study will specifically provide information on inflation management in Ghana prior to the establishment of MPC and post establishment of the MPC to determine any significant change in parameters.

Table of Contents

Chapter I Introduction

Background Information

Problem Statement

Organization of Study

Objective of Study

Methodology

Limitation of Study

Relevance of Study

Research Questions

Key Terms

Chapter II Literature Review

What is Inflation?

Problems Associated with High Inflation rates

Inflation Targeting

Proponents of Inflation Targeting

Opposition to Inflation Targeting

Alternatives to Inflation Targeting

Adoption of Inflation Targeting in Emerging Economies

Chapter III

Data Analysis

The Case of the Bank of Ghana and the Adoption of Inflation Targeting

Ghana Prior to the Adoption of MPC

Ghana After the Adoption of MPC

The MPC and Inflation Management/Targeting in Ghana

Inflation Targeting

The current Inflation Outlook

Results of Monetary Management

Results and Findings of the adoption of Inflation Targeting in Ghana

Ghana and Inflation targeting assessment

Chapter IV

Summary of the study

Chapter V Conclusions and Recommendations

Chapter I

Introduction

Throughout the world emerging economies are confronted with the task of managing inflation. The management of inflation is essential to ensuring that the economy will be profitable and sustainable over time. Economies that cannot stabilize inflation rates will have difficulty growing and flourishing over the long run and the quality of life for citizens will suffer.

The country of Ghana, located in West Africa, has undergone many changes over the past few decades as a result of gaining its independence. With this new found independence came the need to embrace an effectual monetary policy so that the economy can prosper. According to Breisinger et al. (2009) Ghana has achieved a significant level of sustained growth during the past two decades. This success is due in part to "improvements in policies and the investment climate, increases in investments

and aid inflows, and favorable world cocoa and other commodity prices (McKay

and Aryeetey, 2004; Bogetic et al., 2007). The most recent national household survey data suggests that, based on current trends, the country will reach the first

Millennium Development Goal (MDG One) of halving 1990's poverty rate by

2008 (GSS, 2007; Breisinger et al., 2008). Thus, Ghana is bound to become one of only a few African countries that are able to achieve 'MDG

One' earlier than the target year of 2015 (Breisinger et al., 2009)."

The success in economic growth and decreasing of poverty that Ghana has experienced has inspired the country to present of new development goal that involves reaching middle-income (MIC) status by 2015 through the utilization of a second Growth and Poverty Strategy or GPRSII (Breisinger et al., 2009). The realization of this particular objective necessitates that Ghana will double its per capita DP from $450 to $1,000 during the next decade. Improving the nation's GDP by this amount will require a great deal of economic expansion (Breisinger et al., 2009). Although such growth may be a challenging endeavor, it is not an impossible scenario. The author reports that other developing countries have achieved such growth but the drivers of such growth differ from country to country. The author also concedes that the realization of such growth is dependent upon the willingness of the country to undergo substantial structural changes within the economy (Breisinger et al., 2009). Additionally, "Structural change (or economic transformation) is a dynamic process that involves the evolution of the sectoral composition of output and employment, and labor productivity over time (Syrquin, 1988, Pieper, 2003; (Breisinger et al., 2009))."

For the nation of Ghana these structural changes have come in the form of inflation targeting implemented by the Bank of Ghana. This monetary policy is designed to stabilize inflation and thus prices. Such stability is what the country needs to prosper economically and meet the aforementioned goals.

The purpose of the research to follow is to provide an in depth explanation of Inflation Targeting as a monetary policy tool in Managing Inflation. The research will focus on several factors that led to the adoption of this policy and why this policy was chosen over other monetary policies.

Problem statement

Ghana and emerging economies throughout the world face the challenge of stabilizing inflation so that the economy can flourish. In Ghana high inflation rates were impeding upon the ability of the nation's economy to expand. Inflation targeting is a tool that can be utilized in an effort to make inflation rates more predictable over time. The ability to make inflation rates stable over time is essential to economic growth because it stabilizes prices, encourages investment and secures employment opportunities. Additionally, Monetary Management by the Central Bank as a major arm of economic policy management in Ghana has by law and practice often focused on price stability.

Yet over the years in Ghana, monetary policies implemented by the central bank has had a history of strong inflationary pressures from a triple digit in the early seventies and eighties to double digits in the nineties and is currently battling to attain single digit. Even, the strict monitoring of fiscal and monetary aggregates under the International Monetary Fund/World Bank sponsored Structural Adjustment Program (SAP) could only yield an average inflation of about 25% p.a between 1986 and 2000. Clearly inflation continues to be a major problem for policy makers in Ghana.

Objective of the Study

The study proposes to reveal the effectiveness of Inflation Targeting as a policy tool in managing inflation by the Central Bank. The study will also explain why in the face of falling interest rates the Ghanaian Central Bank still achieves its desired objectives of lower rate of inflation. The study will specifically provide information on inflation management in Ghana prior to the establishment of MPC and post establishment of the MPC to determine any significant change in parameters. Studies on inflation targeting in general have been done by renowned economist like Frederic Mishkin et al., Nii Kwaku Sowa, (to mention a few) however my studies focuses on the inflation targeting strategy adopted by Central bank of Ghana.

Methodology

The methodology will involve the use of time series data taken from a sample period between 1972 and 2008. This data will be collected and analyzed. Data sources shall include among others, MPC reports, national budgets and publications from the research department of BOG. The data collected will be divided into two sub-samples, that is, regime before the establishment of MPC and post MPC era. Using the following money demand model,

Md = P* L (R, Y)

Where Md is amount of money demanded, P is the price level, R is the nominal interest rate and Y is real output.

The data will be tested to determine the stability of money demand function over the two eras.

The study will also draw conclusion based on the use of secondary research. This research will be derived from books, journals, reports published by the Bank of Ghana, the government and the International Monetary Fund.

Limitation of Study

As a result of the time constraint and difficulty in obtaining economic data, this study will be restricted to the period between 1972 and 2009. Additionally, the study is limited in that the official adoption of the MPC and inflation targeting has been relatively recent.

Relevance of Study

This study is significant because it will allow central banks in other countries to review the use of inflation targeting as a monetary policy in Ghana. Through this analysis emerging markets will have a better understanding of how this monetary tool works and whether or not it is a tool that is effectual for the purposes of lowering and stabilizing the rate of inflation. Within the Ghanaian context some in the business community belong to the school of thought that Inflation Target leads to the increase of interest rate and consequently the cost of doing business in the Ghana. This is evidence by the stated position of the Association Ghana Industries' negative reaction to the MPC's decision to raise the prime rate from 17% in December 2007 to 18.5% in February 2008. In undertaking this study, it is expected that the findings would prove the usefulness of Inflation Targeting as a good monetary policy tool in enhancing output and invariably lowering inflationary pressures. The findings of this study will bring both the Central Bank and the business community together in the pursuant to attain price stability

Research Questions

The research questions for this discussion are as follows,

1. Why did Ghana adopt an inflation targeting strategy?

2. Were there any significant changes in parameters for inflation management in Ghana prior to the establishment of MPC when compare to after the establishment of the MPC?

3. Has the implementation of inflation targeting served to improve the Ghanaian Economy?

4. Have rates of inflation stabilized over time in Ghana?

5. What are the macroeconomic indicators that reflect the presence of disinflation in Ghana?

Key Terms

Developing economy, Disinflation, Emerging Economy, Inflation, Inflation targeting, Macroeconomic, Monetary policy

Chapter II

Literature Review

What is Inflation

Inflation is defined as "the overall general upward price movement of goods and services in an economy, usually as measured by the Consumer Price Index and the Producer Price Index." Inflation is an important economic indicator because over the long run as the costs associated with goods and services rises the value of money decreases because people do not have the capacity to purchase as much as they once did. The monetary policies of a nation are able to, to some extent, control the rate of inflation.

In recent years there has been some belief that globalization has altered the nature of inflation. According to Ball (2006) recently various countries have increased trade with one another. As a result some economist believe that globalization of the economy has impacted the way inflation behaves. In fact, Greenspan (2005) asserts that globalization "would appear to be [an] essential element of any paradigm capable of explaining the events of the past ten years," including low inflation. The Economist (2005) says that increased trade "makes a mockery of traditional economic models of inflation, which generally ignore globalization (Ball, 2006)."

Ball (2006) further asserts that even if globalization has no impact on long-run inflation, globalization does impact shot-run inflation. In most cases short run inflation is calculated with the use of the Phillips curve. This curve appears as follows:

= ?(-1) + ?(Y-Y*) + ?,

Where?

is inflation, ?(-1) is lagged inflation, Y is output, Y* is potential output, and ? captures shocks to the inflation process. Y-Y* is the "output gap." Some people suggest that globalization has made the traditional Phillips curve is no longer useful in determining inflation. For instance, President Fisher of the Dallas Fed (2005) asks rhetorically

"How can we calculate an "output gap" without knowing the present capacity of, say, the Chinese and Indian economies? How can we fashion a Phillips curve without imputing the behavioral patterns of foreign labor pools? How can we formulate a regression analysis to capture what competition from all these new sources does to incentivize American management?"

Ball and other economists argue that it is impossible to truly know and understand inflation rates if globalization is not taken into consideration. The impact of globalization on inflation has already been felt and will likely continue to be an issue for years to come as the world becomes increasingly more connected. As a result of the increase in globalization there will likely be changes in the way that monetary policies are developed.

Problems associated with high inflation

High inflation can be a serious problem for any economy. According to Freedman & Laxton (2009) the most noticeable cost of high inflation is the impact that it has on long-term decisions that are made by investors and savers. These decisions are based on the future price of goods and services, as such decision makers react based on the price movements that are expected. Over many years of study economists have found that

"high rates of inflation are associated with more volatile rates of inflation. In such

circumstances, if a decision maker finances a long-term project with long-term debt, it is exposed to the risk of losses in the case of an unexpected disinflation, and if it finances the project with short-term debt, it is exposed to funding risk.

These risks will make decision makers less likely to invest in a project that is otherwise viable (Freedom & Laxton (2009)."

In addition, high inflation leads to unrealistic expectations associated with the impact of high inflation on asset prices in the future. These unrealistic expectations can lead to bubbles in asset prices. Examples of these unrealistic expectation can be seen in the real estate market. For instance, a family may purchase a home or an investor may purchase commercial property at a price that is overvalued. However, they will not know that the asset is overvalued until some time in the future. This results in poor investments that do not yield the intended profits. In addition the authors explain that "The effect on investment decisions of inflationary distortions will result in the capital stock being smaller and/or less productive than otherwise would have been the case. The level of potential output will thus be negatively affected by periods of high rates of inflation (Freedom & Laxton (2009)."

In addition studies have shown that distortions are also problematic because they have the potential to lead to a decline in the grow rate of output. More specifically research has indicated that there is a nonlinear relationship between output growth and inflation. That is, there is a threshold level of inflation beyond which inflation has a negative impact on growth and under which inflation has no impact on growth. One researcher, Khan and Senhadji (2000) found that the threshold was between 1 and 3% for industrialized countries. The researchers also found that the threshold for developing countries to be 7-11% (Freedom & Laxton, 2009). The research suggests that there is an extremely wide confidence interval for developing countries. This confidence interval is recorded at 1-20% (Freedom & Laxton, 2009).

Another cost associated with high rates of inflation involves the distortion of relative prices. The author explains price changes are not identical because firms alter their prices at different intervals. As such, it is common for relative prices to not be reflective of relative costs associated with production. As a result of the distortion of relative prices welfare losses will occur because consumers and producers will make poor decisions.

Tax codes are also adversely affected by inflation. The authors explain that many tax codes are established upon the idea of price stability. This means that most tax codes fail to consider the effect that inflation has on financial statements or the profitability of a firm.

"In the case of the corporate income tax, this shows up most importantly in the treatment of depreciation, inventory valuation, and interest costs. Since depreciation for tax purposes is based on the original cost of the capital assets, it underestimates the reduction in value over time in current dollars of the asset in question, thereby overstating profits and corporate taxes. Use of historical costs in determining the cost of goods that were sold during the current period but had been produced in earlier periods and held in inventory will also result in an overstatement of profits and corporate taxes (Freedom & Laxton, 2009)."

Additionally, throughout inflationary periods, interest paid on corporate debt is inclusive of an inflation premium and the real interest rate (Freedom & Laxton, 2009). Although the inflation premium is an allowable tax deduction, it is also the offset of the capital gains on equipment and machinery. These gains are not included as an aspect of income. With this understood when the inflation premium is used as a deduction there is a understatement of income as it pertains to taxes.

Another aspect of the economy that is impacted by high inflation is labor negotiations. Labor negotiations are affected by inflation because of the uncertainty that occurs related to the rate of inflation in the future. On the one hand unions have a desire to protect members against high rates of inflation during the time of active contracts (Freedom & Laxton, 2009). On the other hand, employers are concerned that costs will be to great if inflation continues to increase. As such both unions and employers are faced with difficulties when negotiating labor contracts because of the uncertainty involved concerning the future rate of inflation (Freedom & Laxton, 2009). The authors further explain that high rates of inflations are linked to high inflation volatility (Freedom & Laxton, 2009). This often means that laborers are more likely to strike at times of high inflation than during low or predictable inflation. Such strikes result in a loss of work and productivity which can adversely affect the firm and ultimately the overall economy (Freedom & Laxton, 2009).

Obviously high inflation rates can be detrimental to the health of an economy. As a result countries throughout the world have employed monetary strategies that serve the purpose of reducing inflation rates. In addition to the reduction of rates, central bankers recognize the need for inflation rates to be stable so that

The negative impact of inflation as it pertains to various aspects of the economy and economic well-being created a need for a tool to control the level of inflation particularly in developing and transitional economies. One such tool is inflation targeting and it will be explained at length in the next section of this discourse.

Inflation Targeting

Inflation targeting has become an important aspect of monetary policy in recent years. According to Alan Greenspan the main purpose of monetary policy is to maintain price stability. Greenspan also explain that "Price stability is obtained when economic agents no longer take account of the prospective change in the general price level in their economic decision making" (Greenspan, 2001; (Batini and Laxton, 2006). This concept is reflected in an annual rate of inflation that is low.

The purpose of inflation targeting is to serve as a monetary policy that encourages the price stability spoken of by Greenspan. The authors explain that inflation targeting is quite different from alternative monetary policies. These alternative policies including money or exchange rate policies which "seek to achieve low and stable inflation by targeting intermediate variables, such as the growth rate of money aggregates or the level of the exchange rate of an "anchor" currency (Batini and Laxton, 2006)." On the other hand inflation targeting is designed to directly target inflation (Batini and Laxton, 2006).

The authors further explain that several definitions for inflation targeting exists. Although there is not a consensus on a single definition, the authors concede that inflation targeting has the two following characteristics which distinguish it from other types of monetary policies:

1. A nation's central bank is directed and commits to a distinctive numerical target as it pertains to a range for yearly inflation (Batini and Laxton, 2006). This single target is reflection of the fact that the central bank is committed to price stability as the primary aspect of its monetary policy. That is, the numerical standard is important because it serves as a guide to measure the price stability the central bank is aiming to achieve (Batini and Laxton, 2006).

2. Inflation forecast beyond a given horizon is the actual intermediate target of monetary policy (Batini and Laxton, 2006). Because this is the case inflation targeting is often described as "inflation forecast targeting" (Svensson, 1997;Batini and Laxton, 2006). In view of the fact that "inflation is partly predetermined in the short-term because of existing price and wage contracts or indexation to past inflation, monetary policy can influence only expected future inflation. By altering monetary conditions in response to new information, central banks influence expected inflation and bring it in line over time with the inflation target, which eventually leads actual inflation to become better anchored to the target (Batini and Laxton, 2006)."

In addition to these two characteristics, there are also six principles related to inflation targeting. These six principles are as follows:

1. The primary purpose of monetary policy is to present a foundation for the economy by placing weights on other objectives that are consistent with presenting an anchor for inflation and inflation expectations (Batini and Laxton, 2006).

2. A successful inflation-targeting policy will contain beneficial first-order influences on welfare through the reduction of ambiguity, the stabilizing of inflation expectations and decreasing the occurrences and severity of boom-bust cycles (Batini and Laxton, 2006).

3. Additionally the success of an inflation targeting policy is dependent on the other policies adopted by the regime these policies can make the mission of monetary policy simpler and more credible (Batini and Laxton, 2006).

4. As a result of the delays in the monetary transmission mechanism in addition to the concern over the divergence of inflation from its target and the variation of output from potential, it is "neither possible nor desirable to keep inflation exactly on target and in practice inflation targeting becomes inflation-forecast targeting (Batini and Laxton, 2006)."

5. When a clash exists between inflation targets and other objectives, central bankers must possess reasonably clear objectives and adequate independence from the political process to realize the predetermined objectives (Batini and Laxton, 2006).

6. The bank must have effectual monitoring and accountability instruments to guarantee that central bankers are conducting business in a manner reflective of the announced fundamental objectives and that monetary policy is decided using sound practices (Batini and Laxton, 2006).

Freedom & Laxton, (2009) also contend that there are some main characteristics of Inflations targeting. The authors assert that different researchers have differing ideas about what these characteristics are, but the basic point of these characteristics is comparable. For instance, Bernanke (1999) maintains that inflation targeting is a structure for monetary policy exemplified by "(i) the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and (ii) the explicit acknowledgment that low, stable inflation is monetary policy's primary long-run goal. Among other important features of inflation targeting are (iii) vigorous efforts to communicate with the public about the plans and objectives of the monetary authorities, and, in many cases, (iv) mechanisms that strengthen the central bank's accountability for attaining those objectives (Freedom & Laxton, 2009).

Mishkin (2007) defines inflation targeting in a similar manner but adds an additional component. This component is that inflation targeting is an information dependent strategy in which several variables, and not only monetary aggregates or the exchange rate, are utilized for decision making as it pertains to the monetary tools that are set in place. Mishkin (2007) also explains that the attributes of inflation targeting should elucidate one vital position: "it entails much more than a public announcement of numerical targets for inflation for the year ahead." According to Mishkin (2007) making this distinction is critical particularly for emerging market countries because many of the nations regularly announce numerical inflation targets as an aspect of the government's economic plan for the year to come (Mishkin 2007). However, their monetary policy strategies are not consistent with inflation targeting, which necessitates that the other components for the monetary policy to be sustainable throughout the medium term (Mishkin 2007).

While the above definitions are based on so-called full-fledged Inflation Targeting (FFIT), some emerging economies use less developed forms of inflation targeting. These less developed form are usually done as groundwork for FFIT or as a result of concerns regarding the consequences of obligating themselves to FFIT. The less developed versions usually entail enduring some component of exchange rate targeting combined with inflation targeting. A less developed version might also contain less transparency and communication with the public than a FFIT (Mishkin 2007).

Proponents of Inflation Targeting

Many economists around the world advocate and encourage the implementation of inflation targeting as a monetary policy. Batini and Laxton, (2006) further explain that supporters of inflation targeting assert that it produces several advantages when compared to other types of monetary policies (Truman, 2003): These advantages are inclusive of the following:

Inflation targeting can insist in the development of credibility and secure inflation expectations more quickly and robustly. Inflation targeting is advantageous in this regard because it emphasizes the fact that low inflation is the chief goal of monetary policy. It also necessitates a great amount of transparency to balance out the more significant operational liberty that comes with the adoption of such a policy. Additionally, inflation targets are also inherently succinct, easier to manage and more understandable than other types of targets. Targets have these attributes because they usually do not vary over time and they are also controllable through monetary processes. Because this is the case Inflation targeting can assist economic agents in gaining a better understanding of how to the performance of the central bank. In addition economic agents have a greater ability to stabilize inflation expectations more rapidly and more permanently than policies in which the job of the central bank is less obviously defined and more difficult to observe (IMF, 2005; Batini and Laxton, 2006).

Inflation targeting is more flexible. Because inflation cannot be constrained immediately, placing a target on inflation is usually viewed as a medium-term goal. As such it is purported that central banks practice inflation targeting beyond a certain horizon, by concentrating on keeping inflation expectations in line with the target. Additonally, short-term variations of inflation from the target are tolerable and do not inevitably become losses in credibility. Additionally "The scope for greater flexibility could reduce variability in the output gap ( Batini and Laxton, 2006)."

Inflation targeting requires a lower economic cost if the monetary policy fails. The author explains that "The output costs of policy failure under some alternative monetary commitments, such as exchange rate pegs, can be very large, usually involving massive reserve losses, high inflation, financial and banking crises, and possibly debt defaults.12 in contrast, the output costs of failing to meet the inflation target are limited to inflation that is temporarily higher than targeted and growth that is temporarily slower, as interest rates are raised to bring inflation back to target ( Batini and Laxton, 2006).."

Indeed, according to Mishkin (2004) there are five main reasons why inflation targeting should be utilized. These reasons are as follows

1. Public declaration of future medium-term statistical targets for inflation. This is important because it causes those making economic decisions accountable because the public has been made aware of the inflation targets ( Mishkin, 2004).

2. A fundamental dedication to price stability as the most important, long-term purpose of monetary policy and to the achievement of the inflation target ( Mishkin, 2004). Those that govern monetary policy related to inflations targeting are committed to the strategy this commitment guarantees that the strategy will be successful ( Mishkin, 2004).

3. A strategy that contains the most detailed information available. Having access to the proper information available guarantees that the implementation of such a policy will be in congruence with the economic reality facing the country ( Mishkin, 2004).

4. Improved openness concerning the approach of the monetary policy through communication with the public and the markets concerning the plans and objectives of monetary policy makers.

5. Improved accountability of the central bank for achieving its inflation objectives ( Mishkin, 2004).

The author further explains that inflation targeting is good and necessary

"Because an explicit numerical inflation target increases the accountability of the central bank, inflation targeting is also more consistent with democratic principles. Sustained success in the conduct of monetary policy as measured against a pre-announced and well-defined inflation target can be instrumental in building public support for a central bank's independence and for its policies. The granting of operational independence to the Bank of England in 1997 illustrates this point. On May 6, 1997, the new Chancellor of the Exchequer, Gordon Brown, announced that the Bank of England would henceforth have the responsibility for setting interest rates, which previously was done by the Chancellor of the Exchequer. In the press conference, Gordon Brown explained that the inflation targeting regime justified the government's decision: the Bank had demonstrated successful performance over time as measured against an announced clear target, and was now more accountable, making it more responsive to political oversight (Mishkin, 2004).

This aspect of the literature review demonstrates that there are certain principles that should be present as it pertains to an effectual inflation targeting policy. The literature also indicates that transparency and communication are a major aspect of inflation targeting. These factors seem to contribute greatly to the development and implementation of an inflation targeting policy.

Opposition to Inflation Targeting

Although many economists believe that inflation targeting is absolutely necessary as an aspect of a stable economy, there are some economists that oppose such a policy. One of the primary objections to inflation pricing involves inflexibility. According to some economists the inflexibility of inflation targeting results in higher output fluctuations.

In addition, other have taken the position that assert that inflation targeting may be too rigid and may meet the same fate as the constant-money growth-rate rule established by Milton Friedman. However, many economists believe that such a characterization is inconsistent with the true nature of inflation targeting which is quite flexible as opposed to rigid.

Alternatives to Inflation Targeting

Although the monetary policy of inflation targeting has grown in popularity in recent years, there are also various alternatives to this type of monetary strategy that have been attempted in economies throughout the world. According to Jonas & Mishkin (2003) in the sphere of economics the 1990's will probably been known as the decade when fixed exchange rate economic systems became less popular as supposed anchors for the performance of monetary policy (Jonas & Mishkin (2003). The authors explain that financial crises dictated the need for many emerging market countries to discard fixed exchange rate policies, and substitute them for more flexible exchange rate strategies. (Jonas & Mishkin, 2003).

The authors explains that in some instances countries decided to introduce an exchange rate that was more flexible in an methodical manner, without having to exit the peg because of financial crisis or market demands on their currency (Jonas & Mishkin, 2003). This tendency form a set to a more elastic exchange rate policy was visible in the transition economies of Central and Eastern Europe (Jonas & Mishkin, 2003). During the initial transitioning years, in the wake of price freedom and exchange rate devaluation, many transition economies used the exchange rate peg as a type of nominal anchor to achieve the quick stabilization of price level (Jonas & Mishkin, 2003). Nevertheless, as with other emerging market economies, transition economies have also dealt with the common problem of exchange rate-based stabilization programs. The problem occurs because even though inflation has a tendency to decline under such a policy, inflation usually does not decrease enough to stop significant real appreciation that eventually creates a balance of payment problem and force the desertion of the fixed exchange rate (Jonas & Mishkin, 2003).

The authors further explains that some countries decide to adopt a hard version of a fixed exchange rate known as a currency board arrangement, other nations adopt a managed float. For instance, the Czech Republic, the Slovak Republic and Poland adopted such strategies. Although Hungary did not implement a full floating currency policy, it did implement an exchange rate band, which permitted the currency to increase and decline within this band by 15%. The authors also explain that the decision to abandon exchange rate pegs, was based on what nominal anchor to use in place of the fixed exchange rate. The authors posit that "While the Slovak Republic did not accompany the move to a floating exchange rate by an explicit introduction of new monetary policy framework, the other three countries opted for inflation targeting. Why did the authorities in these countries opt for inflation targeting, and why did they reject other alternative policy frameworks? (Jonas & Mishkin, 2003)" the authors declare that the answers to this question can be found in the examples learned from the implementation of alternative monetary policies.

One such alternative is the utilization of monetary aggregates to serve as intermediate targets and a nominal anchor. Yet, targeting monetary aggregates is not always an attractive policy for transitional economies. This lack of attractiveness id due to the fact that "The traditional problem of instability of money demand, and therefore the unstable relationship between the growth of money supply and inflation, could be a particularly serious obstacle to targeting monetary aggregates in transition economies. Economic transition is characterized by a sequence of price shocks, including corrections in administered prices and tax reforms that make the relationship between money supply and price level very difficult to predict (Jonas & Mishkin, 2003)." As such the volatility of money demand and money-price correlation is additionally affected by expansive changes in the financial sector (Jonas & Mishkin, 2003). These changes alter financial institutions and encourage the development new forms of financial assets. With this understood, having a monetary policy that depends completely on targeting money supply growth might be a rather unproductive (Jonas & Mishkin, 2003)..

In addition to monetary aggregates, transition economies may also implement a